Altus Insight - November, 2014
The Altus Insight
Market news, commentary and relevant topics for today’s alternative asset investor
Date: November 30, 2014
FR: Forrest Jinks
RE: Deflation. Is it Possible?
Thanksgiving has long been my favorite holiday. Not only do I get to spend time with family and friends but it is a holiday that makes me consider my situation and each year I realize how much I have to be thankful for. My wife and I were fortunate enough to host this year’s Thanksgiving festivities and most of the guests stayed for the entire weekend. Without ringing phones and computers dinging with incoming email we were able to spend quality time playing games, talking, and of course eating some wonderful food.
Thanks to two gentlemen I met this past month Thanksgiving this year was a little bit extra thankful. As our government continues along the slippery slope of economic interference and (from a historical standpoint) poor financial decision making, I am susceptible to focusing on the bad things that are happening. These two gentlemen reminded me that the US continues to be one of most free countries in the world (ranked #20 in a study I saw this past month, New Zealand was #1) with great opportunities for those willing to do the work to take advantage of them. The American Dream may be more difficult to obtain than in the past, but it is still a possibility; a possibility simply not available in most of the rest of the world.
One of the gentlemen moved here from Mexico when he was a young adult. He met his future wife taking continuing education classes to improve his English. She was a teacher, he was working at Home Depot. They lived in San Jose, an expensive place to live by any measure. Eight years ago they decided they wanted to do more than barely get by. They now own 1,600 apartment units and the cost of living in San Jose isn’t a concern any longer. As you can imagine, he no longer works at Home Depot.
The second gentleman was born in Morocco to a Jewish family in a Muslim country. First his brothers, then he, escaped his situation to Israel where he obtained a two year technical degree in textile manufacturing. A few years later he came to the US, stepping off the boat in New York the mid 60’s with four dollars in his pocket. He ended up starting his own textile manufacturing plant in New York where he gained great success. He now lives on his vineyard outside of beautiful Healdsburg, CA. He is no longer involved in textiles but supports entrepreneurialism through angel investing while also maintaining a substantial real estate portfolio.
I am thankful to these gentlemen and the thousands of men and women like them who are willing to leave what they know to come to the US for a better life. Thanks to their willingness to sacrifice and work hard, all of our lives are also made better. They also provide me a reminder of what is possible if I too am willing to keep pushing forward.
Last month we introduced the possibility of the US entering a deflationary economic cycle and provided several possible causes of such a cycle. As mentioned in that article we structure our investments to take into account those possibilities, not because we have any sort of clairvoyance about the future. This month we will discuss how deflation could affect our investment decisions.
Oil Prices: The last topic discussed in last month’s article was the drop in oil prices. In the past thirty days oil prices have hastened their retreat with the culmination of the month being the OPEC meeting held on the 27th where OPEC members opposed cutting production to prop up oil prices. Prices are now down over 40% since their cyclical high earlier this year. Historically this would be a boon to the US economy as cheaper oil results directly in lower transportation and energy costs both to producers and consumers. The savings in fuel and energy can then be spent on other areas of the economy. Historically, the US imported a vast majority of its oil so changes in oil prices benefited or hurt foreign producers. This has changed. Thanks to discovery of vast new oil fields and advancements in extraction technology, the US is now the second largest oil producer in the world and prior to the recent price destruction was expected to become the largest producer within the next few years. Daily oil production has nearly doubled since 2008 and net US oil imports hit a 28 year low in 2013. This means not only is oil production a much larger portion of the US GDP but a far greater portion of oil profits (or losses) are now staying domestic instead of going to foreign producers.
Various reports have put the average cost of production for a barrel of US oil at between $59 and $85/barrel. Forgetting for a second that the discrepancy is almost silly in its size, even at an average price of $59/barrel, and certainly at an average price of $85/barrel, there are a lot of oil wells losing money at the current market price of $67 per barrel.
Texas, and to a lesser extent North Dakota, has been the star of the economic recovery (be it what it is) since the Great Recession. Texas is doing some great things to attract and keep a wide variety of businesses in the Lone Star State, but the fact remains that the increase in oil production and processing has been a substantial part of the state’s economic growth. Not only are there profits from the production itself but increased production also benefits an economy through higher employment, large extraction capital expenditures, product transportation, and refinement. At $67 per barrel the profit simply won’t be there for many wells and expansion into new oil fields will (and already are) be put on hold until oil prices recover at some point in the future. While the Texas economy is far more diversified than it was in the 1980s when a crash in oil prices created an economic implosion not seen since the 1930s, there is no question that their economy, and by extension the economy of the US, will be affected by the lower prices.
Beyond the obvious investing takeaways related directly to oil (there may be some great oil stock or lease buys soon), there is also a caution for real estate investors. Texas, and especially Texas apartments, has been a favorite child for real estate investors for the past several years. Great caution should be taken before allocating investment funds into Texas real estate, especially in areas built up due to the oil boom. This isn’t to say the Texas economy is going to experience its own recession or that there are no good real estate investment opportunities in Texas, it is just something to keep in mind when reviewing opportunities.
Interest Rates: Economist Lane McGhee emailed me in response to last month’s article. His feedback was he thought it likely that we would see increasing interest rates despite the other economic factors. If correct, our concern regarding deflation should really be about stagflation, a much more difficult environment in which to invest. Lane’s appreciated input aside, for now stagflation will be added as another option in the list of economic possibilities. If instead true deflation does take hold, it is likely that interest rates will not increase as so many people expect, and instead could fall below where they are now. Not possible you say? Look at interest rates in Europe where in some cases they are not just lower, they are negative. Two year bond rates for Germany, Belgium and Ireland have spent time below zero, as have three year rates for Germany and Switzerland. This means the governments are getting paid to borrow money. In Ireland’s case, they are getting paid to borrow money despite a massive (relatively speaking) debt default only a few years ago.
We don’t know how low interest rates will go but we do know they can, and may, go lower, and that possibility changes how we look at our own debt structure. For the past several years we have been focused on extending our interest rate lock period as far out as was feasible, and with plans to hold properties through the entire lock period, the chance of being hurt by this strategy is much lower than by being hurt by rising interest rates. The issue however, comes in a scenario where an asset needs to be sold. The longer the interest rate lock on debt, the higher the prepayment penalty on that debt. Fannie Mae, Freddie Mac, and other institutional lenders often have prepayment penalties calculated as ‘yield spreads’ or ‘defeasance’. Yield spread requires that the borrower pay a penalty equal to the difference between the locked interest rate and then market interest rate in order to pay off the loan. Defeasance is explained here. Both prepayment calculation methods can be extraordinarily expensive if rates fall from the market rates at the time the loan was first made. This cost can easily be enough to eliminate the chance of selling a property. We were considering a 304 unit apartment building in Tulsa, Ok. The existing loan of $3.1 million had an interest rate of 5.96% with another 9 years remaining on the interest rate lock and included a defeasance prepayment penalty. We could have assumed the loan but explored the possibility of paying it off since at the time market rates for 10 year fixed money were close to 4%. To pay it off we would have had to purchase just under $6 million worth of US Treasuries, the entirety of which would have sat in an account controlled by the lender who also would have received the interest rate from those bonds during the entire 9 years remaining on the existing loan.
Reducing exposure to prepayment penalties is not easy and may require paying higher initial interest rates or shortening the interest rate lock component of the loan. Because we aren’t willing to make guesses on which way the economy will move over the next several years we are more likely to accept marginally higher interest rates as opposed to sacrificing interest rate lock periods. In some cases is may make sense to shorten the lock periods in which case we will try and increase the amortization rate of the loan so there is less loan principal exposure at the time of the lock expiration.
Additionally, the amount of leverage used may be worth considering. If properties are being leveraged to their highest allowable loan-to-value ratios with the expectations of rising rents, and then those rents don’t rise, the debt may become overly burdensome. This will be an interesting dynamic to watch over the next several years because we believe there is a shortage in the rental markets, especially apartments in many areas, which would indicate increasing rents, even in the face of deflation.
Geopolitical Instability: Deflation can sometimes be good for an individual citizen since the purchasing power of their savings will increase. Debt holders, for whom repayment of the debt becomes more expensive as the value of a single unit of currency increases, want to avoid deflation at all costs. Hence Ben Bernacke’s comment several years ago that he would fly a helicopter over the country dumping cash as he went rather than fall into deflation. Governments are the largest holders of debt in the world while also having large social obligations to their citizens. In the US the elephants in the room are the unfunded Medicare and Social Security liabilities. Other countries have similar issues. The drop in oil prices exacerbates these issues. Russia, the world’s third largest oil producer, ran their 2015 budgets assuming oil at $100/barrel, and that was prior to the crash in value of the ruble. Saudi Arabia has direct cost of oil extraction of a ridiculously low $7 per barrel, but according to an article in the Oil and Gas Financial Journal, they need oil to be above $97/barrel to break even fiscally. Political hotspots Iran and Iraq’s fiscal breakeven is estimated to be at $126/barrel and $106/barrel respectively. It should be noted that the US hasn’t been fiscally break even since the Clinton Administration so running a country in the red is not a sure path to war, however many countries, and certainly including Russia and Iran, do not have the same access to the capital markets as does the United States. Without money to run the country, social programs are often the first thing to get cut and as is currently evident in Russia, when the economy is bad and the government wants to deflect attention, the war drums start beating.
It isn’t just oil producing countries that are at risk of instability due to deflationary pressures. Japan, with its massive and unprecedented effort to import inflation through devaluation of the yen, is simultaneously creating tension with its South Asian export driven neighbors who are suddenly at an exporting disadvantage due to the changes in currency values. China and Japan’s little row over the oft ignored and little used Senkaku islands likely a preview of additional spats to come.
The elevated risk of geopolitical instability doesn’t lead directly to an investment strategy conclusion. Volatility across most investment types has been quite low for some time which would be expected to change as instability increases. Volatility is much more of a concern to a day trader than to an investor, especially an investor with cash flow producing investments. We therefore will continue to focus on cash flow production as a main qualifier in our investment decisions.
Inflation or Deflation? There is no crystal ball and if there was there would be no opportunity to outperform the general market. The best we can do is be aware of the possibilities, be aggressive when we are appropriately hedged or incentivized, and be defensive when unknowns outweigh the knowns. In all cases and over the long run, patience and discipline will outperform emotion and rashness.
Altus Equity Group, LP